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Office Subleases Portend Softening Fundamentals

Landlords across the nation are competing for tenants not only with other property owners, but also with tenants that are offering space on the cheap for sublease. While the amount of subleases available today isn’t alarming, researchers say it is a growing trend that signals softening fundamentals today and declining rental rates ahead.

“It’s definitely a predictive indicator of softening in the general leasing environment,” says Matthew Wright, client services manager in the Philadelphia office of Grubb & Ellis. “The confluence of increases in sublease space on the market and decreased tenant demand will certainly have an impact on softening of rental rates.”

In the 12 months ended at midyear 2008, tenants added 13 million sq. ft. of offices to the inventory available for sublease nationwide, a gain of 18%, Grubb & Ellis found. As usually happens in commercial real estate cycles, the increase in sublease inventory that began last year has been followed this year by an increase in space available for direct lease.

Negative absorption measured 3.25 million sq. ft. in the second quarter of 2008, reversing a five-year trend of positive absorption, according to Wright, who co-authored a national sublease report that Grubb & Ellis published this month. Negative absorption reflects tenant contraction, or users giving space back to the landlord as old leases expire rather than renewing or leasing larger digs.

“We saw subleasing begin to tick up in the third quarter of 2007 and negative absorption picked up in the second quarter of 2008,” Wright says.

The slowing economy is driving companies to return space to the market, whether through subleasing or simply giving offices back to landlords, says Alan Pontious, senior vice president and managing director of office and industrial properties and Marcus & Millichap. “We’ve had what will amount to our ninth straight month of job losses,” he says. “There’s no disputing that sublease space is growing as a result of the environment we’re in.”

What do increasing subleasing and negative absorption mean for most of the nation’s office markets? Based on previous cycles, commercial real estate experts say declining rents are just around the corner. Asking rents will begin to decline in the fourth quarter and will bottom out around the middle of 2010, according to projections by Boston-based Property & Portfolio Research.

Office landlords are currently asking for an average rental rate of $55.98 per sq. ft., but that rate is expected to fall to $48.99 before it begins to climb again in the second half of 2010, PPR predicts. “What we’re expecting is for rents to recede and basically wipe away most of the rent gains from 2007,” says Andy Joynt, a real estate economist at PPR’s New York office.

So far, however, rents are holding. Even in Manhattan, which has seen available Class-A sublease offerings double since the first of the year, asking rent is holding to a lofty $85.72 per sq. ft., according to Cushman & Wakefield. “Asking rents aren’t moving yet,” says Ken McCarthy, Cushman & Wakefield’s managing director of New York research. “Rents have stopped rising, but we haven’t seen them fall.”

Yet anecdotal evidence suggests New York landlords are keeping an eye on the recent increase in sublease offerings, McCarthy says. Perhaps more importantly, some landlords are forming plans to better compete with the additional Class-A offices that many financial firms are likely to vacate and offer for sublease as this month’s drama on Wall Street unfurls.

“One thing we understand landlords are looking at is building out space, if they’re competing with space on the market that’s already built out,” McCarthy says. “Tenants don’t want to spend money on build-outs.”

All else being equal, finished sublease space is difficult for landlords to compete with. Where subleases are available, a tenant can expect to pay 25% to 40% less in rent for a sublease than the going market rate, according to tenant representation specialist Marc Miller, an executive vice president at Winoker Realty Co. in New York. “That’s about a third off, and many of these spaces come furnished, some with phone systems,” he says.

Companies are willing to accept below-market rent on subleases because they are motivated to reduce their own expenses rather than to seek a profit, explains Robert Sammons, director of research in the New York office of Colliers International. In Manhattan and many other U.S. office markets, the companies most likely to offer sublease space are financial services firms because that sector is experiencing the most job losses these days.

Consequently, the space they have to offer is typically Class-A with excellent locations, furnishings and amenities. “A lot of this space has a good bit of time left [on the master lease] and it’s trophy space,” he says.

Landlords can help to maintain their property values in the coming years by retaining tenants, but that job will grow progressively more difficult as subleasing gives tenants more options and more bargaining power, says Pontious of Marcus & Millichap. “For about the next 24 months, a landlord today has got to be high on customer service and really prudent with operations,” he says.

Tenant representative Miller agrees, contending that the key for landlords today is to retain tenants and keep them happy. “If there’s an electrical dispute or a tax dispute on a certain invoice, the landlord may want to swallow it,” Miller says. “The tide is turning slowly but surely to a tenant’s market.”